Introduction
Gift tax
Estate tax
Reporting to the IRS
Generation-skipping transfer tax
Transfer tax rules likely to change as of 2013
Income tax
Income tax residency and transfer tax domicile
Anti-avoidance rules
Reporting foreign bank accounts
US citizens and green card holders living abroad
Expatriation
Comment
US persons, both individuals and trusts, and non-US persons with US investments have seen an increase in their US tax reporting obligations over the last few years. In addition, the gift and estate tax rules have changed – and are likely to change again – for US citizens and non-citizens domiciled in the United States. Uncertainty abounds as to income and transfer tax rates. However, there is no uncertainty as to the efforts of the Internal Revenue Service (IRS) to identify and prosecute taxpayers who do not file the required returns and fail to pay any resulting tax. Advisers to international families must be aware of the shifting US tax landscape and how it impacts on family trusts and holding companies, as well as individual family members. US citizens and non-citizens resident in the United States are subject to US gift and estate tax (sometimes referred to together as a transfer tax) on their worldwide assets, and to US income tax on their worldwide income. Individuals who are not US residents or citizens ('non-resident aliens') are, generally speaking, subject to the US transfer and income tax systems only on US situs property and US source income.
US citizens and US residents
Transfers of property – whether real property, tangibles or intangibles, and wherever located – by US citizens and US residents are subject to US gift tax. There is a small annual exclusion for gifts up to $13,000 per donee (for tax year 2011, indexed annually for inflation). Direct payments of medical and educational expenses are exempt from gift tax, even if not required by a legal obligation of support, as in the case of an adult child. The US donor may double the annual exclusion amount (to $26,000 for tax year 2011) by filing a gift tax return and electing to split the gift with his or her spouse. A tax credit is available for gifts made in 2011 and 2012, which shelters up to $5 million worth of lifetime gifts from tax, but then reduces the credit available to use against the estate tax at death. A charitable deduction is available for gifts to qualifying domestic or foreign charities. A marital deduction is available for gifts to a US citizen spouse. The maximum gift tax rate for 2011 and 2012 is 35%. As is discussed later, the amount of the transfer tax credit and the rate of the tax are scheduled to change as of 2013, but legislation may be introduced with new tax laws.
Non-resident aliens
Transfers of intangibles by non-resident aliens are not subject to US gift tax, even if the intangibles are US property (eg, stock in a US company). As a result, only real property and tangible personal property located in the United States are subject to the US gift tax when transferred by a non-resident alien. Advisers to international families will want to seek competent US tax advice on the possible conversion of property from taxable property (eg, tangible US situs property) to tax-free property (eg, intangible stock) prior to making the gift.
The resulting tax can be substantial if the US gift tax system applies to a non-resident alien, due to the following limitations on credits, exclusions and deductions, as compared to gifts by a US citizen or resident:
- No credit against gift tax is available to a non-resident alien (unlike estate tax, where a credit shelters assets worth $60,000 from tax in the estate of a non-resident alien).
- A non-resident alien is entitled to the gift tax annual exclusion that allows tax-free gifts of $13,000 per year per donee (for tax year 2011, indexed annually for inflation), but the non-resident alien cannot double this amount using the election to split gifts with the donor's spouse, even with a US citizen spouse.
- The non-resident alien's charitable gifts of US property qualify for a gift tax deduction only if made to a domestic US charity.
- The US gift tax marital deduction is also likely to be limited for non-resident aliens as a practical matter. Non-resident aliens are entitled to tax-free transfers under the US gift tax marital deduction, just as a US citizen, but no such deduction applies if the recipient spouse is not a US citizen, regardless of the transferor's status. A donor can make tax-free gifts to a non-citizen spouse of up to $136,000 per year (for tax year 2011, indexed annually for inflation). Gifts free of trust will usually qualify for this exclusion. However, careful planning is needed for gifts in trust, since the spouse's interest must be both a deductible interest under marital deduction concepts and a gift of a present interest under the annual exclusion rules.
Return filing
The gift tax return (Form 709)(1) is an annual return filed not earlier than 1 January of the year following that in which reportable gifts were made and no later than April 15. It is possible to extend the time to file the return, but this does not extend the time to pay any gift tax due.
US citizens and US residents
The worldwide estate of a US citizen or US resident is subject to US estate tax. An estate tax credit shelters up to $5 million from tax (for estates of decedents dying in 2011 and 2012), to the extent not used to offset gift tax on lifetime transfers. A charitable deduction is available for bequests to qualifying domestic or foreign charities. A marital deduction is available for bequests to a US citizen spouse. The maximum estate tax rate for decedents dying in 2011 and 2012 is 35%. As mentioned, transfer tax rules are scheduled to change as of 2013 (for a detailed discussion, see below).
Non-resident aliens
For non-resident aliens, a significantly broader list of property is subject to US estate tax, as compared to gift tax. In general, the property is subject to US estate tax if it has a US situs. US real estate and tangible property physically located in the United States, and securities or obligations issued by US persons or entities, are US situs property and subject to tax unless specifically excluded by the Internal Revenue Code.
Most importantly, however, US property includes stock in a US company, but not stock in a non-US company. Thus, the non-resident alien may be able to avoid the estate tax by investing in US property through an offshore holding company or mutual fund. The US estate tax rules generally do not look through these offshore companies, except in special circumstances. With careful planning, investments in US property by a non-resident alien can be made through offshore companies, usually owned in turn by an offshore trust. The offshore company must have the characteristics of a corporation and the form must be respected by the shareholder. In addition, the company should acquire the US property, rather than having the shareholder (ie, the non-resident alien or the non-resident alien's trust) acquire the property and transfer it to the company.
The use of offshore companies and trusts requires careful planning. Otherwise, a non-resident alien decedent who funded the trust with US property and retained the right to amend the trust or receive trust income may be subject to US estate tax on the value of the trust assets. The fact that the US property is later converted to non-US property prior to the settlor's death (eg, by contribution to the non-US corporation or by sale and investment in non-US property) does not change the result under the literal language of the Internal Revenue Code.
If the US estate tax applies, the non-resident alien's transfers at death are more severely taxed than those of a US citizen or resident. The threshold level for tax-free transfers is very low and deductions are limited as follows:
- The non-resident alien's estate tax credit shelters only the first $60,000 from tax at the lowest tax brackets, rather than the first $5 million to which estates of US citizens and residents are entitled for tax years 2011 and 2012.
- The deduction for debts and expenses of the estate of a non-resident alien is very limited. Only a proportion of recourse debts and the expenses of a non-resident alien's estate are deductible, based on the value of the US property and the value of the decedent's entire worldwide estate. The estate of a non-resident alien must disclose the decedent's worldwide assets to the IRS in order to take the full deduction in calculating US estate tax on the decedent's US situs property.
- The estate tax charitable deduction is also limited. The non-resident alien's charitable bequests qualify for an estate tax deduction only if made to a domestic US charity.
- Transfers to or for a surviving spouse can be sheltered completely from US estate tax by the marital deduction, just as for a US citizen – except that if the surviving spouse is not a US citizen, property must pass to a qualified domestic trust in order to qualify for the deduction, even if the spouse is resident in the United States.
The scope of the estate tax is reduced significantly for non-resident aliens who qualify as residents of treaty countries that have a modern treaty with the United States (eg, the United Kingdom, France and Germany). These modern treaties still allow the United States to tax its citizens wherever resident. However, residents of treaty countries who are not citizens of the United States benefit from the treaty because estate and gift taxation on their transfers is limited, in general, to transfers of US real estate and to amounts associated with a 'permanent establishment' located in the United States – a term of art akin to a fixed place of business of the decedent (eg, proprietorship or interest in a business partnership).
Thus, these persons can transfer US equities free of the US estate tax. They may also be entitled to a pro rata share of the estate tax credit available to US persons, based on the ratio of US property to all property. However, treaty protection does not mean that the assets of a non-resident alien will actually pass free of tax, since the estate is likely to be subject to estate or inheritance tax by the home country.
Persons who remain in the United States for an extended period are unlikely to obtain any such treaty relief, even if there is a treaty between the United States and their home country. As a practical matter, these individuals are unlikely to qualify under the treaty as residents of their original home country and, instead, would likely be considered as residents of the United States.
Return filing
The estate tax return (Form 706 or Form 706NA) is due nine months after the date of death. It is possible to extend the time to file the return, including an automatic six-month extension, but this does not extend the time to pay any estate tax due. In addition to reporting trusts created by the decedent and trusts under which the decedent possessed any power, beneficial interest or trusteeship, the executor must also disclose the decedent's transfer to a trust of any interest in a partnership, limited liability company or closely held corporation. Executors must file the estate tax return at the Cincinnati Service Centre, regardless of whether the decedent was a US citizen residing in the United States, a resident alien or a non-resident US citizen.
Qualified domestic trusts
Property passing from a US spouse to a qualified domestic trust for the benefit of a non-citizen spouse is entitled to an estate tax marital deduction on the death of the US spouse. A qualified domestic trust ensures that trust principal will eventually be subject to tax, either upon the distribution of principal from the trust during the surviving spouse's lifetime or at the surviving spouse's death, as if it had been included in the estate of the US spouse. A qualified domestic trust can be established by the US spouse, the surviving non-citizen spouse or the executor of the deceased US spouse's estate. Only property which passes from the deceased US spouse to a qualified domestic trust, or which passes to the surviving non-citizen spouse and is then irrevocably transferred or assigned to the qualified domestic trust in a timely manner, qualifies for the estate tax marital deduction.
A trust is a qualified domestic trust only if:
- the trust instrument provides that at least one trustee is a US citizen or a US corporation;
- the trust instrument provides that no distribution of corpus may be made unless the US trustee has the right to withhold from the distribution the amount of estate tax;
- the trust meets any other requirements that the secretary of the treasury may impose to ensure the collection of estate tax; and
- the executor of the deceased US spouse's estate elects to have the qualified domestic trust provisions apply to the trust.
Foreign gifts and bequests
US citizens and residents who receive a gift or bequest from a non-US person are required to report to the IRS, on Form 3520, the date of the gift or bequest, a description of the property and its fair market value. If more than a specified amount ($14,165 in 2011) is received from foreign corporations or partnerships and treated as gifts, the US recipient has a reporting obligation. For gifts from foreign individuals and estates, the reporting threshold is $100,000. A US recipient's receipt of a distribution from a revocable trust that is considered to be owned by a foreign person is treated as a gift to the US recipient and reported as such. However, if the trust is a foreign trust (as discussed below), the US recipient has an obligation to report the receipt of the distribution regardless of the amount received.
Distributions from foreign trusts
The US recipient of a distribution from a foreign trust is required to file Form 3520 with the IRS to report the distribution, regardless of the amount of the distribution received or its tax consequences to the recipient (there is no such reporting requirement for distributions from a US domestic trust). The Hiring Incentives to Restore Employment Act 2010 (commonly known as the HIRE Act) broadened the tax law to provide that the use of property held in a foreign trust after March 18 2010, by a US grantor or US beneficiary (or any US person related to a US grantor or US beneficiary), will be treated as a distribution to the US grantor or US beneficiary of the fair market value of the use of the property. This deemed distribution rule will not apply to the extent that the foreign trust is paid the fair market value for the use of the property within a reasonable period of such use.
Form 3520 is generally due on the same date as the recipient's income tax return.
Generation-skipping transfer tax
US citizens and US residents
When a US citizen or resident makes a transfer to a person two or more generations below that of the transferor (a 'skip person'), whether such transfer is made during life or at death, a generation-skipping transfer tax (often referred to as the GST tax) is imposed in addition to any gift or estate tax that may be due. An exemption of $5 million (for tax years 2011 and 2012) is available to shelter gifts or bequests from generation-skipping transfer tax. The tax is calculated at a flat rate equal to the top transfer tax rate (35% for 2011 and 2012).
Non-resident aliens
The reach of the generation-skipping transfer tax for transfers made by non-resident aliens matches the reach of the estate and gift tax on the underlying transfer. Thus, a transfer by a non-resident alien of non-US property is not subject to the generation-skipping transfer tax, since it is not subject to estate or gift tax; but the tax applies when a non-resident alien transfers US property (other than intangibles transferred by gift).
Most importantly, the time for testing whether the tax applies is the same time as under the estate or gift tax, even though the 'skip' transfer would often occur later. Specifically, the character of the property and the non-resident alien status of the transferor are tested only at the time of the initial transfer as determined for estate tax purposes (at death) or for gift tax purposes (when the gift is complete). Thus, the generation-skipping transfer tax generally does not apply to transfers by non-resident aliens of property situated outside of the United States as of the time of the initial transfer.
The non-resident alien transferor is entitled to the same $5 million (for tax years 2011 and 2012) exemption from generation-skipping transfer tax as is a US citizen or resident. However, given the limited reach of the tax to transfers by non-resident aliens, this exemption is much less valuable than it is in domestic estate planning. For non-resident aliens, when the generation-skipping transfer tax exemption is needed, its application is fairly straightforward, but some special rules apply. When the transfer by the non-resident alien is fully subject to the tax, the same principles apply as for US transferors, so the non-resident alien will generally decide when to allocate his or her exemption. When the transfer by the non-resident alien is not subject to the generation-skipping transfer tax at all, the exemption is not and cannot be allocated. The limited scope of the tax as applied to non-resident aliens can be summarised as follows:
- Non-resident aliens need not consider the generation-skipping transfer tax implications of their transfers unless the transfer otherwise requires the filing of a US gift or estate tax return. For instance, a non-resident alien grandfather who has made a gift of non-US property or intangibles worth $1 million to a US grandchild need not file a US gift tax return and need not allocate any generation-skipping transfer tax exemption because the tax simply does not apply.
- A bequest of non-US property avoids the estate tax and therefore the generation-skipping transfer tax, so the exemption is not needed.
- If the transfer is mixed, so that it is only partially subject to the generation-skipping transfer tax, then a special rule for non-resident aliens applies to calculate the inclusion ratio of the transfer so that the tax can be imposed. The effect of this rule, as in the domestic context, is to encourage the creation of a separate trust in the amount of the allocated exemption, easing administration and minimising taxes.
Return filing
Schedules to the estate and gift tax returns (Forms 706 and 709) are used to report generation-skipping transfers.
Transfer tax rules likely to change as of 2013
The Tax Relief, Unemployment Insurance Reauthorisation and Job Creation Act 2010 enacted transfer tax rules for 2011 and 2012, which impose a transfer tax at a maximum rate of 35% on gifts made and estates of decedents dying before January 1 2013, and a $5 million exemption amount applicable to combined lifetime gifts and transfers at death. Estate assets receive a step-up in basis to date-of-death fair market value for income tax purposes. The estate of a surviving spouse may utilise the unused exemption amount of the deceased spouse. This is often referred to as 'portability' and must be affirmatively elected on the estate tax return of the first spouse to die. Since previous legislation had repealed the estate tax for 2010, the act provided that estates of US decedents dying in 2010 could elect out of the new rules and, instead, choose no federal estate tax and a modified carry-over basis for income tax purposes.
As of January 1 2013 – if no further legislative action is taken – the estate, gift and generation-skipping transfer tax laws will revert to pre-2001 levels, with a top tax rate of 55% (plus a 5% estate tax surcharge on certain large estates) and a $1 million exemption amount applicable to combined lifetime gifts and transfers at death.
US citizens and US residents
A US citizen and any non-citizen resident in the United States for income tax purposes will be subject to US income tax on his or her worldwide income. The top income tax rate for 2011remains at 35% on income over $379,150. The tax rate for qualifying dividends and long-term capital gains remains at 15% in 2011.
Qualified dividend income includes dividends from domestic corporations and from foreign corporations incorporated in a US possession or eligible for the benefits of a US income tax treaty, provided that the treaty includes an exchange of information provision. Dividends from foreign corporations will also qualify for the 15% rate, but only if the corporation's dividend-paying stock is readily tradable on an established US securities market. The qualified dividend rate is not available for dividends paid by a foreign personal holding company, a foreign investment company or a passive foreign investment company. Payments in lieu of dividends (eg, substitute dividends paid on stock loaned from margin accounts) also do not qualify for the 15% rate.
The US income tax system includes an alternative minimum tax structure. The Tax Relief, Unemployment Insurance Reauthorisation and Job Creation Act revised the exemption amounts used in making the alternative minimum tax computations for 2010 and 2011 so as to prevent increasing the tax burden of millions of taxpayers. The alternative minimum tax requires taxpayers to recalculate their income tax under alternate rules that include income otherwise exempt from tax and to disallow certain exemptions, deductions and other preference items. The act did not address the long-term problem that the alternative minimum tax will present after 2011.
It remains to be seen whether income tax rates and exemptions will change now that Congress and the president have approved legislation that raises the debt limit and cuts spending.
Non-resident aliens
A non-resident alien is generally subject to US income tax only on US source income. However, special exemptions for certain types of US source income earned by non-resident aliens have been enacted to promote investment in the United States, to facilitate enforcement or to avoid enacting rules that cannot be enforced. The following two exemptions are the most important.
Portfolio interest exemption
Interest on US bank accounts and on certain portfolio debt instruments is exempt from US income tax when earned by a non-resident alien. In general, portfolio interest is interest on a debt obligation issued by a US taxpayer to a holder whose status as a non-resident alien has been substantiated in a certain specified manner provided by the tax rules. The effect is that the interest is not subject either to regular US income tax or to withholding tax.
Capital gains exemption and foreign investment in Real Property Tax Act
The second important exemption is that capital gains are generally exempt from US income tax. However, capital gains on real estate or stock in US real estate holding companies are taxed at a graduated rate, as a result of the Foreign Investment in Real Property Tax Act (often referred to as FIRPTA). This act simply treats a non-resident alien's gains from US real estate as 'effectively connected' with a US trade or business, which means that the gains are subject to the same tax regime as domestic taxpayers. This tax is backed up by a special withholding tax regime.
Effectively connected income
'Effectively connected income' is income that is treated as attributable to the conduct of a trade or business in the United States. Broadly speaking, the concept is designed to distinguish between business income and investment income. Thus, effectively connected income is taxable at graduated rates on a net basis that allows related deductions to be used in determining the amount subject to tax, as with the income of a US citizen or resident. This result is considered by the tax law to be appropriate for income derived from assets that are used in an active US-based business or when such a business was a material factor in the production of the income – which essentially defines what is meant by 'effectively connected income'.
'Passive investment income' (ie, income that is not attributed to a US trade or business activity) is either exempt entirely from US tax under the special exceptions for capital gains and portfolio interest or otherwise taxed at flat rates (at 30% withholding on what is called 'fixed or determinable annual income').
Real estate assets often warrant a special election by the non-resident alien owner, because they may or may not be considered a trade or business for this purpose. Rent may thus be taxed as fixed or determinable income taxed at a flat 30% rate rather than as effectively connected income. Net taxation on effectively connected income will often result in lower tax, due to the benefit of deductions, as compared to the 30% withholding regime. This special election is the so-called 'net basis' election.
Withholding tax
Withholding tax refers to a 30% flat rate of tax collected at the source by the US payer of dividends, interest, rents, royalties and the like. The withholding tax is collected on a gross basis, without deductions, but generally reduced substantially by any applicable income tax treaty between the United States and the non-resident alien's home country. The US payer of this income is required to withhold the tax from each payment to the foreign taxpayer and then submit the withheld amount to the IRS. Since many other tax systems around the world have a similar concept, the issue of the rate is often addressed in treaties on a mutual basis. The regime for real property transactions subject to tax under the Foreign Investment in Real Property Tax Act is similar, but it applies different and varying withholding rates and rules depending on the type of payment.
Return filing
Income tax returns (Forms 1040 and 1040-NR) are generally due on April 15 for individuals. It is possible to extend the time to file the return, including an automatic six-month extension, but this does not extend the time to pay any income tax due.
Income tax residency and transfer tax domicile
Resident for income tax purposes
It is possible to become resident in the United States for income tax purposes without any deliberate decision to acquire that status. The following two tests are used to determine residence for US income tax purposes.
Green card test
A lawful permanent resident of the United States for immigration purposes (ie, a green card holder) is conclusively resident for income tax purposes.
Substantial presence test
US income tax residency will be acquired by an individual who regularly conducts business or otherwise maintains a physical presence in the United States, and who does not engage in very deliberate planning to avoid exceeding the limit on days spent in the United States, even if that person's permanent home is outside of the United States. The substantial presence test consists of two separate and alternative tests: the 183-day test and the three-year formula test.
Under the 183-day test, a person who is physically present in the United States for at least one-half of the year (ie, 183 days or more) in a given calendar year, and who does not qualify for any special treatment as a student, teacher, diplomat or similar will be conclusively considered a US income tax resident, unless a treaty tie-breaker provision applies. Relief may be available to qualified residents of treaty countries. If a modern US tax treaty applies, the income tax residency of an individual who is considered resident by the domestic law of both countries can be resolved under a treaty tie-breaker rule that generally looks to the following factors in descending order:
- where the individual has a permanent home;
- the centre of vital interests;
- habitual abode; and
- citizenship.
A person who is a US income tax resident under the Internal Revenue Code but not under the treaty tie-breaker rule can claim non-resident status for all purposes of computing his or her US income tax liability, not just for treaty purposes.
It will still be difficult for the non-resident alien to avoid residency, even with fewer days of presence, once the limit under the three-year formula test is exceeded. The formula limit is exceeded if:
- the time spent in the United States is at least 31 days in the current calendar year; and
- the total days over the current year and the two prior calendar years exceed 183 days (after multiplying days in the immediately prior year by one-third and days in the next prior year by one-sixth).
If the formula limit is exceeded, the client will avoid US income tax residency only if he or she can qualify for a treaty tie-breaker or for the closer connection/tax home exception, which applies if the taxpayer maintained closer ties to another country for the year in question and files the required statement substantiating that claim.
Domiciled for transfer tax purposes
In the gift and estate tax context, 'residence' means domicile, and a person acquires a US domicile when physically present in the United States with the intention to reside there permanently. In general, this means that the immigrant must also have become a lawful permanent resident for immigration purposes, but that is not necessarily the case.
Domicile, unlike income tax residency, is based on facts and circumstances in all cases. Most importantly, domicile is presumed to continue in the foreign jurisdiction until it is established in the United States. The location of business or employment activities does not necessarily determine domicile. Since domicile is less clearly related to current income-producing activities than the US income tax concept of residency, it may be easier to maintain a foreign domicile in a country to which the client currently has no prohibitively expensive tax-producing affiliation. A treaty may also provide relief from the application of the US transfer tax regime. Modern treaties (eg, those with the United Kingdom, France and Germany) provide a tie-breaker rule much like the income tax treaties, but also provide special protection (of varying degrees) for citizens of one country who were not present in the other country for a substantial period of time before the gift or death.
US shareholders of foreign corporations
Several special US tax provisions address ownership in non-US corporations by US persons. Since the United States generally does not tax non-US corporations on foreign source income, these special tax rules are designed to prevent US persons from using non-US corporations to avoid tax by accumulating income offshore. The rules require that certain types of passive income of controlled foreign corporations and passive foreign investment companies be taxed to their US shareholders currently, whether or not distributions are made to them. The effect of these rules can be particularly disruptive if, for instance, a non-US trust in a tax-haven jurisdiction owns one or more such passive investment corporations and the trust has one or more US beneficiaries governed by these rules. Similarly, a non-resident alien shareholder's plan to immigrate to the United States triggers a need for US tax planning.
Temporary loss of residency
The US tax laws contain a special anti-avoidance rule that applies to certain non-US citizens who temporarily abandon their status as a US income tax resident alien. This provision applies to any alien individual who is resident in the United States for at least three consecutive years and thereafter ceases to be resident, but subsequently becomes a resident again before the close of the third calendar year after the close of the initial residency period.
This anti-avoidance rule can have a serious effect. An alien individual who falls within this provision will generally be subject to tax in the same manner as a resident alien on all US source income or gains derived during the intervening period of non-residence – including, for this purpose, all of the special source rules applicable to expatriated citizens and long-term residents. Thus, US income tax will apply to interest income on portfolio debt and any gains from the sale or exchange of property situated in the United States and securities of US issuers.
In computing gain, the IRS has allowed a special step-up provision to apply, so the original pre-residency appreciation can avoid tax. Additionally, gains on US property cannot be avoided by exchanging the property tax free for non-US property, and certain income in controlled foreign corporations will be attributed to the alien.
The principal purpose of this anti-avoidance provision is to prevent resident aliens from avoiding tax on non-recurring US source capital gains by temporarily abandoning resident status. Apart from this rule, US domiciliaries or income tax residents who are not US citizens or long-term residents can immediately shift from worldwide taxation to the limited taxation applicable to non-resident aliens. This rule is of particular importance for persons who have not invested in US real estate and who can leave the United States for a longer period of time and thus avoid the rule.
Reporting foreign bank accounts
The Bank Secrecy Act requires US citizens and residents with financial interests in or signature or other authority over foreign bank accounts, securities accounts and other financial accounts to file Form TD F 90-22.1, commonly referred to as a foreign bank account report (FBAR). FBAR reporting is required if the aggregate value of such financial accounts exceeds $10,000 at any time during the prior calendar year, even if the accounts do not generate taxable income. Although there are many legitimate reasons to hold foreign financial accounts, the IRS stresses that account holders who do not comply with the reporting requirements may be subject to civil penalties, criminal penalties or both. The FBAR must be filed on or before June 30 and requests for a filing extension will not be granted. As it is not an income tax return, the FBAR is filed on its own and not with income tax returns.
On February 24 2011 the Treasury's Financial Crimes Enforcement Network (FinCEN) issued final FBAR regulations. The final rules apply to FBARs which were due by June 30 2011 with respect to accounts maintained in 2010 and for those filed in subsequent years (for further details please see "US Treasury Department publishes final rule for foreign bank account reports"). On March 26 2011 the IRS issued a new FBAR form and instructions. The revised instructions reflect the changes made by FinCEN's final FBAR regulations (for further details please see "New guidance and forms to report foreign accounts and use of trust property").
US citizens and green card holders living abroad
US citizens and green card holders are taxed on their worldwide income, regardless of where they live and work. A credit for foreign taxes paid may offset a portion of the US income tax or, alternatively, the taxpayer living abroad may be entitled to a foreign-earned income exclusion, which is adjusted annually for inflation. The amount eligible for exclusion in 2011 is $92,900. Income over this amount is taxed at the marginal tax rates applicable as if the exclusion did not exist, instead of applying the lower tax rates.
An individual who elects to use the foreign income exclusion may also exclude a portion of housing costs. The base excludable housing cost is 16% of the foreign earned income exclusion. Housing costs less than this base amount are not excludable. There is a cap on the excludable housing costs of 30% of the foreign earned income exclusion. The difference between these two amounts is generally the maximum excludable housing costs. The IRS can adjust the 30% cap on excludable housing costs on the basis of geographic differences in housing costs relative to costs in the United States. For example, in 2011 the cap in Hong Kong was set at $114,300 and London at $83,400.
Exit tax
US citizens and long-term residents who relinquished their citizenship or terminated their US residency on or after June 17 2008 may be subject to mark-to-market deemed sale rules, often referred to as an 'exit tax'. Previously, an expatriating individual who had complied with the required notice and tax filing requirements was thereafter subject to either the US income tax imposed on non-resident aliens or the 10-year alternative income tax imposed on expatriates who met specified income tax or net-worth criteria (for more details please see the Overview (March 2008)).
Covered expatriates
The exit tax rules are applicable only to 'covered expatriates'. A covered expatriate is an individual:
- whose average annual net income tax for the period of five taxable years ending before the date of the loss of US citizenship is greater than $147,000 (for tax year 2011, subject to an annual cost-of-living adjustment);
- whose net worth is $2 million (not indexed for inflation) or more, as of the date of the loss of US citizenship; or
- who fails to certify under penalty of perjury that he or she has met the requirements of the Internal Revenue Code for the five preceding taxable years, or fails to submit evidence of compliance as required by the IRS.
A covered expatriate is not:
- a dual national from birth where, following expatriation, the individual continues to be a citizen and tax resident of the other country, provided that he or she has not been resident in the United States (under the income tax substantial presence test, discussed above) for more than 10 of the last 15 years; or
- a person under 18 and a half years of age who has not been a US resident for more than 10 years under the income tax substantial presence test.
A covered expatriate may spend time in the United States without becoming taxable as a US person, unless he or she becomes a US tax resident under the substantial presence test.
Deemed sale rule
The exit tax rules treat most of a covered expatriate's worldwide property as if it had been sold for its fair market value on the day before expatriation. The covered expatriate will owe income tax on any resulting recognised gain in excess of a $600,000 exemption amount (adjusted annually for inflation), but only with respect to appreciation that occurred while he or she was a US citizen or a US lawful permanent resident. There are special rules with respect to eligible deferred compensation items (eg, most interests in pension or similar retirement plans, certain annuity plans and property to be received in connection with the performance of services) and specified tax deferred accounts (eg, individual retirement accounts and health savings accounts) (for further details please see "New tax law applicable to expatriates").
Grantor and non-grantor trusts
If a covered expatriate is treated as the owner of a trust (or a portion thereof) under the grantor trust rules, then the assets held by that trust (or portion of the trust) are subject to the deemed sale rule upon expatriation. The deemed sale rule does not generally apply to non-grantor trusts (for an explanation of when a trust is considered a grantor or non-grantor trust for US tax purposes, please see "Taxation of offshore trusts and impact of new lower tax rates").
In the case of a non-grantor trust, before making a direct or indirect distribution to a covered expatriate, the trustee must deduct and withhold an amount equal to 30% of such part of the distribution portion that would have been includable in the covered expatriate's gross income if he or she were still subject to US income tax. The covered expatriate is treated as having waived any right to a treaty reduction in the amount withheld. If the trustee distributes appreciated property to a covered expatriate, the trust is treated as having sold the property for its fair market value and must thus recognise any gain.
If a non-grantor trust converts to a grantor trust, the covered expatriate – who is considered the trust's owner – is treated as having received a distribution from the trust, which will trigger the 30% withholding tax. If a grantor trust converts to a non-grantor trust after the individual expatriates, such trust will continue to be treated as a grantor trust for purposes of the deemed sale rule. The impact of the deemed sale rule upon the change of a trust's tax status is important because the expatriation of the trust's grantor can cause a grantor trust to become classified as non-grantor for US income tax purposes.
Election to extend time for payment
A covered expatriate may irrevocably elect to extend the time for payment of the tax resulting from the deemed sale on a property-by-property basis, provided that he or she is willing to provide the IRS with a bond or other form of security. The tax will thereafter be due when the applicable items of property are actually disposed of (or upon the date of such covered expatriate's death, if earlier). The covered expatriate must also waive any right to claim treaty benefits with respect to such tax liability in order to qualify for the election. Interest on the deferred tax will be charged at the individual underpayment rate (currently 6%).
Tax on gifts and bequests from covered expatriates
In addition to the exit tax to be paid by the covered expatriate, the exit tax rules impose a transfer tax on US persons who receive gifts or bequests from the covered expatriate.
Covered gifts and bequests
The tax applies to certain gifts and bequests in excess of the $13,000 annual exclusion amount (adjusted annually for inflation). Gifts and bequests to a US citizen spouse or US charity are not subject to the tax. Covered gifts and bequests do not include property on which the covered expatriate, or his or her estate, is otherwise subject to gift or estate tax and which is reported on a timely filed gift or estate tax return. Tax on covered gifts and bequests will be imposed at the highest gift or estate tax rate which is in effect at the time (35% for 2011 and 2012), less any foreign gift or estate tax paid.
Income and net-worth tests applied at time of transfer
The determination of whether the transferor is a covered expatriate is made at the time of the gift being given or upon his or her death, regardless of whether the transferor was a covered expatriate at the time of expatriation. Thus, a US person may be subject to gift or estate tax upon the receipt of a gift or bequest from an individual:
- whose wealth increased following expatriation; or
- who expatriated prior to the effective date of the exit tax rules, but is considered a covered expatriate as of the time of the gift or bequest.
Domestic and foreign trusts
The trustee of a domestic trust who receives a covered gift or bequest must pay the tax from the trust, unlike the trustee of a foreign trust who does not. Instead, the US beneficiary of the foreign trust pays the tax when he or she receives a distribution attributable to such gift or bequest. A foreign trust may elect to be treated as a domestic trust for purposes of the gift and estate tax.
Advisers to international families should keep a close eye on US tax developments. US tax counsel may be helpful in navigating the complex and expanding reporting obligations.
For further information on this topic please contact Jennie Cherry or George N Harris Jr at Kozusko Harris Vetter Wareh LLP by telephone (+1 212 980 0010), fax (+1 212 751 0084) or email ([email protected] or [email protected]).
Endnotes
(1) Tax forms are available from www.irs.gov.